S&P Warns of ‘Hot Money’ in High-Yield ETFs

By Brendan Conway

Standard & Poor’s is warning of “new and risky” dynamics in the market for high-yield bonds, owing to the entry of easy-to-trade exchange-traded funds.

Here’s how the ratings firm’s managing director of global fixed income research Diane Vazza and Evan M. Gunter, associate director, put it in a note from yesterday:

[T]he ease with which investors can enter and exit ETF investments creates new and risky dynamics in the speculative-grade market with the potential flow of “hot money.” Speculative-grade companies have a higher default risk than investment-grade companies. Therefore, when the credit cycle turns against investors, losses from defaults can quickly outstrip the additional interest payments that high-yield investors receive. Since we are entering the stage of declining credit quality in the current credit cycle, the credit quality of an issuer or a portfolio has become paramount.

With that warning, most of the research is geared toward dissecting the portfolios of the two big junk-bond ETFs, the SPDR Barclays Capital High Yield Bond ETF (JNK) and the iShares iBoxx $ High Yield Corporate Bond Fund (HYG). Point one: The junk-bond ETFs hold a few hundred bonds apiece, versus the 1,500 or so rated by S&P. This magnifies the importance of the bonds held by the ETFs.

JNK comes off as slightly “junkier” than HYG by some measures, but not overly so:

The distribution of bond ratings within these ETFs helps to highlight the differences in total returns. HYG has a higher portion of bonds rated ‘BB-’ and higher (44.4% of its net assets) than either JNK (39.8%) or the overall speculative-grade market (40.3%). When the speculative-grade market is expanding, such as we have seen year to date, higher rated securities tend to lag the performance of the lower rated ones.

In fact, HYG has a slightly bigger chunk of the lowest-rated bonds. Both ETFs have bigger proportion of CCC+ and lower bonds than the overall market:

We estimate that issues rated ‘CCC+’ and lower comprise 7.9% of the overall speculative-grade market. In comparison, HYG holds a slightly greater share (11.0%) of these issues in its portfolio than either JNK (9.8%) or the overall market. The proportion of ‘CCC’ to ‘CC’ rated issues is especially important because these issues typically offer the highest yields. Higher allocations to these credits can fuel returns and outperformance when the speculative-grade market is expanding, but they are also the riskiest credits and the most likely to experience losses once the cycle turns negative.

But the proper question is compared to what? Junk-bond ETFs are like a chainsaw: They clear more brush than the weedwhacker investors previously owned. If you’re not careful with the more powerful tool, you could cut off your hand. It doesn’t mean you should never own a chainsaw.

Correction, Soft, Uncallused Hands Dept., 12:04 p.m.:Jason Zweig of the WSJ points out that the tool of art in the first iteration of this post, a “buzzsaw,” is usually table-mounted, for cutting wood. “Chainsaw” was the mental image. (Growing up in suburban Boston, I didn’t clear a lot of brush.)

About Focus on Funds

As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.